Most Australasian banks calculate affordability on home loan products utilising a Net Servicing Ratio (NSR), an example can be found here.
Simply, the NSR predetermines the borrowers expenses or commitments, including minimum living expenses, the subject loan commitments and any other financial commitments. The borrower must then evidence a surplus of the borrowers net income over the calculated expenses. Each lender has there own criteria on the amount of surplus required, the level of minimum living expenses used and what amount to use as loan commitments (ie. a buffer over the current commitment might be used to allow for interest rate rises).
The other common methodology of calculating borrower affordability is DTI – Debt to Income ratio. This method is a more traditional method and is more common in Europe and USA. The formula is: total annual financial commitments as a % of annual gross income. Most lenders generally require a ratio of below 30%, though DTI’s of 50% would not be uncommon.
High levels of DTI is one of the primary causes of the “sub prime” credit crisis.
A collection of procedures and information that is developed, compiled and maintained in readiness for use in the event of an emergency or disaster.
Events such as the “Auckland power crisis” and “Y2K” have highlighted the need for banks to establish disaster recovery and business continuity plans as part of the their overall operational risk management framework.
Severe events such as these can leave a bank unable to fulfill some or all of its business obligations, particularly where its physical, telecommunication or information technology infrastructures have been damaged or made inaccessible. This can result in significant financial losses to the bank, as well as broader disruptions to the financial system through channels such as the payments system.
When developing business continuity plans, banks should identify critical business processes, including those dependent on external vendors or other third parties, for which rapid resumption of service would be most essential. For these processes, you need to ensure that a bank has identified alternative mechanisms for resuming service in the event of an outage.
Finally, banks should periodically review their disaster recovery and business continuity plans so that they are consistent with the bank’s current operations and business strategies.
You might have noticed a ton of operational risk roles being advertised over the past couple of years … thats bacause under Basel II, Banks are required to demonstrate Op risk is part of their overall risk management plan in addition, they must hold capital for their operational risks. The Basel Committee define operational risk as:
“The risk of loss resulting from inadequate or failed internal processes, people and systems or from external events.”
There is no greater example of a failure of operational risk than the recent Westpac error
Operational risk excludes risk assocaited with credit and market risk but also strategic and reputational risk. Operational risks can be summarised in the following catergories:
- Internal fraud
- External fraud
- Employment practices and workplace safety
- Clients, products and business practices
- Damage to physical assets
- Business disruption and system failures
- Execution, delivery and process management
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Probability of default (PD) is a common expression used within Risk Management - very simply, its the likelihood a borrower will default on their loan (or some other form of obligation). PD is expressed as a percentage, the higher the %, the greater the chance a borrower will default.
A Bank generally calculates PD based on the performance of other loans with similar characteristics.
Banks will have a range of “risk grades” – these grades (or buckets) are aligned with a range of PD’s. eg. Risk Grade “A” might have a PD range of 0% – 0.1%, meaning all loans within this risk grade have a less that 0.1% chance of defaulting. Often risk grades determine pricing of loans - referred to as interest margin.
Whilst PD is important, the risk assocaited with the concept is it assumes that the past patterns of loans and borrowers will be replicated in the future. Accordingly, Banks must validate their risk grades and associated PD models frequently.
Pillar 3 of the Basel accord deals with “market discipline” – basically Pillar 3 promotes Bank entities to disclose on a regular basis their financial information, including details of the banks capital structure and its solvency.
In additional to standard (IFRS) accounting information, Banks must also disclose items which are considered material. Information is considered material if its omission or misstatement could change or influence the assessment or decision of a user relying on that information.
In New Zealand, the RBNZ stipulate minimum requirements for the disclosure statements, click on the following links for examples of disclosures of NZ Banks:
Bank regulators (the Reserve Bank in New Zealand and APRA in Australia) and the Basel accord stipulate that a Bank must hold minimum capital the equivilant of 8% of their assets.
Simple !
The only tricks are 1/. there are limitations on the level of tier 2 capital and 2/. the asset values are adjusted based on the assessment of their ”riskiness” – this is referred to as “risk weighted assets”. Example: a housing loan might carry a 50% risk weight, meaning 4% of capital is required against that asset as it is generally considered low risk.
Generally the Regulators determine what the “risk weight” must be, however under Basel II, “Advanced Banks” are treated a little different … but thats another post.
As stated in my previous post, Bank Capital is basically the value of investment the shareholder holds in the company.
However, Banking Regulators and the Basel accord catergorise capital into various “tiers” based on the quality of capital and its ability to readily absorb losses.
Tier 1 capital primarily includes shareholders equity (shares) that hold no restrictions or conditions, are fully paid-up and immediately available ie. if losses occur, it has a direct effect on the shareholders investment.
The other primary source of Tier 1 capital is retained earnings – that is, profits earnts and retained within the company.
Tier 2 capital is generally less available to absorb losses and typically consists of subordinated debt - This is where an investor provides a loan to the bank rather than buying equity (or a shareholding) in the company – it can be considered a form of capital because in the event of liquidation, it has a lower priority to normal creditors (this includes bank customers holding deposits within the bank) – hence the term subordinated.
There other more complex forms of Tier 2 capital and I’ll look to discuss these at some later stage. Yikes – theres even Tier 3 capital.
What better place to start ?
Most countries have “signed up” to the Basel II accord, a framework designed to determine the appropraite level of capital held by banks in order to absorb any losses and to adequately protect deposit holders. Simple ? … not really.
The accord is actually quite complex in places, but Im going to keep it simple and “high level” for this post.
The main component is what is referred to as Pillar I (thats a 1) that details how a bank must calculate the level of capital it holds (capital is basically the value of the shareholders investment). eg. if a bank makes a loan for $1,000 – the shareholders must have $x invested in the company, generally this is around 8%, or in this case $80. The rest of the funds ($920) they can borrow to then on-lend. Pillar I of the accord determines if the % is appropriate given the riskiness of the $1,000 lent.
The Basel II accord has taken a bit of a criticism in recent times as it failed to stop the recent financial crisis and the high number of bank failures / bailouts. The criticism is fair in my view, there is no question that the accord wasn’t complex enough to match some of the complexities surrounding derivative instruments of trading banks. I plan to go into some of this detail at some later stage (a bit heavy for my 2nd post).
Oh and why the name Basel – its a small town in Switzland and is where the Bank of International Settlements (BIS) developed the accord.
Welcome world to my first ever post on nzriskmanager.com.
Why nzriskmanager.com ? Well, Im from New Zealand (thats the nz part), I’m employed as a risk manager for a major NZ financial institution, I have an interest in reading blogs and playing around with wordpress and I hope that this site might be used (in some very small way) by others who are seeking some risk management information…. I’ll wait and see, to be honest, if I only get 1 or 2 visitors I’ll be pretty excited.
A big part of my motivation for this site is the excellent blog managed by these aussies.
